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10 MISTAKES TO AVOIDWHEN TURNAROUND INVESTING

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By Bruce Kaser

The essence of turnaround investing is profiting from a substantial upturn in an underperforming company’s fundamentals. More simply put, it’s buying when things look bad but are actually on the road to improvement.

What is the most powerful factor in successful turnaround investing? Making sure there is a solid and clear reason that the fundamentals–revenues, costs, balance sheet–will improve.

What is the most important way to reduce risk when selecting a turnaround stock?

Buying at a significant discount to underlying value, in other words, buying with a margin of safety.

Most of the mistakes in turnaround investing violate one or both of these two tenets. If fundamentals don’t improve (or worse, deteriorate further), the investment will almost certainly not be successful. If the valuation is not attractive, not only have over-paying investors reduced their upside potential but they also have taken on greater downside risk should the fundamental improvements stall out.

Here are the 10 biggest mistakes you want to avoid:

1. Mistaking a low stock price for being cheap Many stocks trade at low prices, say, under $5 a share; but this is unrelated to whether it is a bargain. What matters is what the shares are worth. You may buy a glass of outstanding wine for $5 and it would be a real bargain. However, $5 for a glass of water would be ridiculously overpriced. Similarly, some $150 stocks are bargains, and some $1 stocks are excessively over-valued.

One perspective I find helpful is looking at the value of the entire company, not the price of one share. Is the entire company worth $1.4 billion? Or perhaps $2 billion? After understanding the big picture, I convert it into a per-share value.

Valuing a turnaround stock can be complicated. To measure valuation, I typically look at Enterprise Value/Ebitda multiples, P/E multiples and perhaps book value multiples or some other asset-based method. I might use trailing, next year’s or a post-turnaround earnings number depending on the company. The important part to remember is to focus not on share price but on valuation.

2. Paying too much attention to price history It can be tempting to look at a depressed stock and think “it used to trade at 40 and now it’s at 8–therefore it must be a bargain.” Unfortunately, the fact that a stock once traded at a higher price does not guarantee that it will ever get back there. There is a big reason that a stock trades so much lower than before: Its earnings potential or assets have deteriorated. Without some fundamental improvement, the share price will continue to lag, or worse.

You want to understand why the stock price has declined and identify what fundamental change will reverse the company’s fortunes. Is the management taking new actions to address the issues? Is the industry cycle turning up? Is something else improving? Only then can the stock have a chance to recover. And remember, the former $40 stock doesn’t need to fully recover. If you buy it at 8 and it goes to 16, even though it is down 60% from its prior price, you still have a 100% gain.

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3. Confusing cyclical and secular problems If a company’s problems are driven by a cyclical downturn in its industry, it has a good chance of recovering once the cycle improves. Industry cycles come and go, and as long as the company remains healthy it will likely recover once the cycle recovers.

However, a secular problem could last for years and possibly forever. Often these relate to obsolescence and irrelevancy. Companies caught in these secular trends must fight steadily declining demand by redefining their products or customers’ buying habits. It’s difficult for a company to meaningfully improve its fundamentals against this kind of headwind.

When a company faces both cyclical and secular problems, a turnaround may be impossible. Coal mining companies saw their product’s price collapse 80% from a cyclical downturn, while at the same time they had to fight the secular forces curtailing demand for coal-fired electricity. In only a few years, the entire publicly-traded coal industry went from an enormous boom to bankruptcy.

4. Being too early Turnaround investors recognize the opportunity in a battered stock well before the rest of the market, and they want to pounce immediately. But even if the fundamentals look attractive and there is a margin of safety in the valuation, the stock can still decline–sometimes substantially. Perhaps an earnings report featured weak headlines that prompted selling by short-term traders, even if beneath the ugly news the company showed real improvement. This price downdraft can be painful to endure.

Timing a turnaround purchase exactly right is very difficult. Getting “close enough” works well given the strong upside potential. One time-tested approach used by pros to reduce the impact of being too early is to buy only a starter position in a new name (maybe half of a typical position). If the stock falls off sharply but the long-term story is intact, these investors will buy more stock at the newly discounted prices.

However, this problem is not so serious as long as you avoid the next mistake.

5. Not being patient enough Turnarounds can often take a long time–in many cases two to four years. And even after the company has begun to turn, it can take the market a while to recognize the change. During the seemingly laborious and perhaps painful wait, it can be tempting to give up. In turnaround investing, the story will often “improve slowly at first, then all of a sudden.” Few things in investing are as frustrating as making a good call but selling the stock just before it takes off.

One valuable technique to help prevent selling too early is to avoid focusing on the stock price. Separate the share price from the underlying business reality. The market moves stocks up and down for many reasons–including macro concerns, political events and Federal Reserve policy guessing, etc. Turnaround stocks tend to have magnified moves that can be totally unrelated to the company’s specific fundamentals. Focus instead on what the company is actually doing: Is management acknowledging and fixing its problems, no matter how slowly it is going? Are any of the key metrics improving, even a little? Is the cycle showing signs of becoming less severe?

6. Being too patient Successful turnaround investing requires patience. But even though turnarounds can take a long time, they should not take forever. Maybe the turnaround just isn’t going to happen–the new management doesn’t have the right formula, or they lose their edge or perhaps a steady stream of new challenges keep hitting the company. There is no easy way to determine how much patience is appropriate; but if

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your turnaround is well into its fourth year without meaningful progress, it could be time to move on. Sometimes investors will get drawn into a variation of “mission creep”–changing the goalposts to justify holding onto the position. Maybe management has come up with a new set of initiatives that sound compelling. Perhaps the investor decides that even though the fundamentals aren’t improving, the buyout value is so high that someone “has” to acquire the company at a huge premium. These are traps that you want to avoid.

7. Not paying enough attention to the debt There is an old saying among turnaround investors: “Earnings and assets come and go, but debt is forever.”

Equity investors sit at the very bottom of a company’s capital structure. Everyone else, including all debt holders, must be fully paid before any value can go to the stockholders. When a company has a high level of debt, its earnings and assets need to cover a lot of obligations. Should those earnings and assets weaken, it can leave a pittance for shareholders and result in a poorly performing stock, or worse.

You can often get a sense of the magnitude of this risk by looking at the price of a company’s bonds. If the bonds are trading well below their face value, it can indicate that stockholders could be in trouble.

8. Buying the stock of a company in Chapter 11 bankruptcyThis is closely related to the previous point. Companies typically enter Chapter 11 bankruptcy because their debts were too high relative to earnings and assets. Very rarely will such a company be able to generate enough value to produce anything for the stockholders. In almost every case, existing shares are cancelled when a company exits bankruptcy, leaving existing shareholders with permanently worthless stock. As tempting as it may seem, buying the stock of a company operating under bankruptcy court protection is almost never a good investment.

9. Putting too much faith in insider buying Company insiders, primarily senior management and board members usually have the closest view of their company’s prospects. As long as they follow specific regulations, these insiders can personally purchase their company’s shares.

These “insider” trades can indicate that those with the best knowledge believe the company will do better in the future. Long before anything newsworthy happens, or before an upturn appears in a company’s financials, an insider may see positive changes and purchase the company’s stock. This can be a sign that “outsiders” should consider buying it too.

However, insider share-buying judgment is not infallible. The insiders may be blinded by their loyalty to the company, may have political pressure to buy shares or may be overly confident in their ability to turn the company around. While not particularly common, top executives have added to their holdings shortly before their company goes bankrupt.

10. Not diversifying enough It is easy to get mesmerized by the potential gains in a particular turnaround and invest too much of your money in it. Remember that turnarounds are inherently risky. Even the best turnaround investors can’t always say ahead of time which investment they hold will be their best or worst performer. Too much is changing in ways that aren’t readily predictable.

While important to any investment program, diversification is critical to successful turnaround investing. Some turnaround stocks will produce very large returns, others may produce small returns and some

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may produce large losses. If you diversify, however, an unlucky pick or two may be more than offset by one or two big gains from other turnarounds you own.

Remember that this is a contrarian strategy with a long-term horizon. Individual turnaround stocks are volatile. Having a diversified portfolio of turnaround stocks will dampen that volatility and help you hold steady.

These are the most common mistakes, but no doubt there are many others. Use these as part of your investing checklist and you can improve your turnaround investment performance.

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This special report is published by Cabot Wealth Network. Cabot is neither a registered investment advisor nor a registered broker/dealer.

Neither Cabot nor our employees are compensated in any way by the companies whose stocks we recommend. Sources of information are believed to be reliable, but are in no way guaranteed to be complete or without error. Recommendations, opinions or suggestions are given with the understanding that readers acting on the information assume all risks involved.

We encourage readers of this report to consult with an independent financial advisor with respect to any investment in the securities mentioned herein. Any opinions, projections and predictions expressed in this profile are statements as of the date of this publication and are subject to change without further notice. Past performance may not be indicativeof future results.

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About Bruce Kaser

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds, and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company, New Generation Research. Prior, he led the event-driven small/midcap strategy for Ironwood Investment Management and was Senior Por-tfolio Manager with RBC Global Asset Management where he co-ma-naged the $1 billion value/core equity platform for over a decade. He earned his MBA degree, in finance and international business, from the University of Chicago and did his undergraduate studies in finan-ce, with honors from Miami University (Ohio).